Money Crazy

How We Overestimated Our Wealth

The world lost $50 trillion in assets last year. If the earth had been beset by plagues, asteroid strikes or killer robots, it would be easy to understand this titanic loss. But because 2008 didn’t bring worldwide physical destruction, where did the $50 trillion go?

A partial answer is that we never really had this wealth. Imagine you have a mine you think is filled with gold. But then a geologist tells you it holds only fool’s gold. You’ll now consider yourself much poorer than before, even though physically you’ve lost nothing.

Analogously, we falsely believed investment bankers could extract gold from subprime mortgages. We thought that by slicing and repackaging, banks could rid these mortgages of much of their risk, a move that seemed to benefit everyone and raised the estimate of our wealth. Financial institutions had trillions of dollars of mortgage-backed securities before the crash. But we now know the securities’ towering values were never justified.

Investment banking attracted many of the world’s best and brightest. We believed they were doing extremely productive work, a belief reflected in the high market capitalization of many financial institutions. In hindsight, we know that many investment bankers were subtracting from the world’s material well-being. Our current, more rational assessment of their productivity has caused us to have a lower but better appraisal of our assets.

Another reason we overestimated our wealth was rising home values. Many mortgage issuers pushed their products on low-income buyers, thinking investment bankers had tamed subprime risk. These buyers’ home purchases raised the demand for housing and therefore increased the value of many existing homes.

At the same time, a bubble caused housing prices to become irrationally high, even taking into account the effects of subprime mortgages. Normally, the price of an asset reflects its long-term value, but because of the bubble and excessive subprime lending, our homes are worth far less than we thought. So although the crash didn’t destroy our homes, it did cause us to value them less.

A third way we overvalued our wealth was that we underestimated our debts. Imagine you suddenly found out that several years ago your spouse had racked up huge debts. You would consider yourself poorer today than you did yesterday even though in a real sense your wealth hadn’t diminished.

The U.S. government had long ago implicitly guaranteed the debts of Fannie Mae and Freddie Mac. It also had an unspoken too-big-to-fail policy regarding large financial institutions, meaning if that they ever got into real trouble, the federal government would bail them out to prevent collapse.

But because we underestimated the risk of mortgage-backed securities, we also underestimated the expected cost of the debt to taxpayers. The crash suddenly forced us to confront the magnitude of our commitments.

The crash did, of course, also destroy real wealth by causing much of the world’s financial system to collapse, inducing governments to spend trillions to try to restore economic order. But the crash also caused us to have a more realistic view of our well-being. In the long run this could help our economy.

For example, now that we don’t overvalue homes and investment bankers, fewer of our resources will go to them. And that means we’ll devote more resources to more productive outlets.

James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Sur­viv­ing and Thriving in a Smarter, Richer and More Dang­erous World (BenBella Books), on sale in October.